Hedge Funds In Mutual Fund Clothing: 
The Best of Both Worlds?

In our Summer 2004 issue, we discussed hedge fund investors being forced to pay tax on “phantom income” – tax on profits that are never earned (see “Hedge Fund Challenges”).  Ironically, plain old mutual funds do not have this problem.  And a good number of mutual funds now employ hedge fund strategies.

Hedge fund investors’ tax difficulties stem from the fact that the funds generally send investors K-1s that break out gross profits and fees separately.  Moreover, some hedge funds categorize their management fees as “miscellaneous itemized deductions,” which most investors cannot use.  In contrast, mutual funds are allowed to net their gains, income and expenses each year.

Besides tax efficiency, these mutual funds are compelling for many economic reasons.  First, they have no incentive or performances fees.  And while management fees on these vehicles are high for mutual funds, they are low by hedge fund standards.  Expense ratios may appear higher than they actually are because short dividend expense is considered as part of the expense calculation.

Like other mutual funds, these mutual funds offer daily liquidity-- quite an advantage over regular hedge funds’ standard of quarterly liquidity with 30 to 45 day advance notice. In order to offer this daily liquidity feature, mutual funds must limit their ownership of illiquid, hard-to-price securities, and there is a limit on leverage.

By Securities and Exchange Commission estimates, there is $13.7 billion invested in these alternative investment mutual funds.  Lake Partners of Connecticut, which had traditionally allocated dollars to hedge funds, has found the mutual fund space interesting enough to create a managed account consisting entirely of mutual funds acting like hedge funds.

A Matter of Style

Most of the mutual funds employing hedge fund trading strategies are long-short mutual funds.  We’ve also found two merger arbitrage funds, one convertible arbitrage mutual fund, a covered call writing fund, distressed debt funds and a fixed income arbitrage fund.

The Center for International Securities and Derivatives Markets at the University of Massachusetts released a study in March 2004 that analyzed a sampling of these funds. The study concluded that mutual funds employing alternative investment strategies were doing a good job of representing their respective investment “styles”.

The categorization of these mutual funds could prove difficult – especially for funds that employ the hedged equity investment style. If a fund is not required to always be balanced long and short, does it deserve to be in this group? According to the SEC, in 2003, approximately 3900 mutual funds were permitted to short, but only 236 actually did so.

For Long-Short Technology Investors

While hedged mutual funds may be the more tax-efficient tool for many investment styles, investors who want to bet on long-short technology portfolios should consider Merrill Lynch TRAKRS (a loose acronym for Total Return Asset Contracts).   Individuals investing in TRAKRS receive long-term capital treatment after only six months and will only pay tax on net income.  (See “TRAKRS” in the Fall 2003 Tailored Solutions.) 

The Bottom Line

Mutual funds that invest like hedge funds may offer hedge fund-like returns -- but without hedge fund liquidity issues, incentive fees, or taxes on “phantom” profits.  We believe these funds are worth a look.  And for investors who want to bet on a long-short technology portfolio, TRAKRS take tax efficiency even a step further.